David Einhorn's Apple Proposal Is Just Financial Engineering — You Can't Get Something From Nothing

Hedge fund manager David Einhorn, who is one of the smartest
investors on Wall Street, is trying to force Apple to consider a plan that he believes will
"unlock value" for Apple shareholders.

Einhorn wants Apple to issue a new class of preferred stock that
will pay a 4% dividend in perpetuity.

Einhorn argues that Apple's issuing this stock will immediately
create hundreds of billions of dollars of new wealth for Apple
shareholders, by "unlocking" the value of the cash on Apple's
balance sheet.

Although anything is possible--the stock market sometimes behaves
in strange ways--it is important to note that Einhorn's plan does
not actually create any new value for Apple or Apple
shareholders.

It's just financial engineering.

And assuming investors aren't currently being completely stupid
in evaluating Apple's assets and business, this financial
engineering should not deliver a huge boost in wealth for those
who own Apple stock.

Einhorn is certainly entitled to his opinion, and there's no way
to prove what value the market is actually attributing to this
cash versus the value the market is placing on Apple's business.
All we know is that, together, the market values the cash and the
business at about $430 billion.

As I explained in
detail in this article, that value looks low relative to the
combination of Apple's business and Apple's cash. But since the
value of a stock is based in part on what happens in the
future--and because no one knows what will happen in the
future--no one knows for sure what Apple is worth.

This "no one," it must be said, includes David Einhorn. All we
know is that, relative to current earnings, Apple's
stock looks cheap.

(Importantly, if Apple's business and profit margins decline over
the next few years, Apple's stock is not currently
cheap. BlackBerry and Nokia looked cheap in the years before their
businesses collapsed. So did Palm. None of those stocks were
actually cheap. I don't think Apple's business will
collapse, but I do
think their profit margin will decline. The question is how
much. The bottom line is that, no matter how confidently people
tell you that they know what will happen with Apple over the next
few years, they don't know. They also don't know whether the
stock is cheap or whether the market is correctly valuing Apple's
cash. All they know is that the stock looks cheap.)

So, anyway, David Einhorn wants Apple to give shares of a new
class of preferred stock to current shareholders.

These preferred shares will pay a 4% dividend.

Einhorn suggests that Apple issue $50 billion of this preferred
stock, which will mean paying out $2 billion a year in new
dividends.

Einhorn suggests that this will "unlock" the value of all the
cash on Apple's balance sheet and finally clue the market into
the fact that it is not valuing that cash properly.

I think the market probably is valuing the cash on
Apple's balance sheet properly.

I think that if Apple published a press release tomorrow morning
saying that an employee had embezzled the entire $137 billion of
cash and then vaporized, Apple's stock value would drop by about
$137 billion. Apple is the single-most-scrutinized public company
in the world, and I think the market is, in aggregate, very much
aware of how much cash Apple has. And I think the market is
probably assigning a perfectly reasonable value to it.

If Apple issued $50 billion of new preferred stock, this
preferred stock would be "senior" to Apple's common stock--the
stock that trades for about $450 a share these days. What that
means is that, if Apple got liquidated tomorrow, the folks who
owned the preferred stock would get $50 billion off the top
before Apple's common shareholders got anything.

If the market is behaving even remotely rationally, the market
should therefore respond by knocking the value of Apple's common
stock down by about $50 billion.

In other words, if Apple issued $50 billion of this new class of
preferred stock tonight, the price of Apple's common stock should
open tomorrow at about $400 a share.

Why?

Because no matter how good a financial engineer you are, you
can't just wave your magic wand and make something out of
nothing.

If Apple issues this stock tonight, the value of Apple's
enterprise and assets will not change. All that will change is
the form of ownership of, and claim on, these assets. And the
folks who own the $50 billion of preferred stock will have a more
senior claim on those assets than the folks who own the common
stock.

Einhorn may believe--and he may be right--that Apple's issuing
preferred stock will befuddle mom and pop investors who won't
take the time to understand that they now have a claim to less of
Apple's assets than they did before.

And Einhorn may hope that, as a result of this befuddlement, the
market will misprice the preferred stock and common stock, thus
allowing him to do what every financial engineer wants to
do--appear to create something out of nothing.

And, again, Einhorn may be right. He's brilliant. And anything is
possible.

But Einhorn shouldn't be right. If the market is behaving
rationally, Apple's overall value should not change. The issuance
of new preferred stock should reduce the value of the outstanding
common stock, such that the transaction is effectively neutral.

Furthermore, if the goal is to "unlock value," issuing preferred
stock is needlessly complicated.

Instead of issuing new preferred stock, Apple should just
significantly increase its regular dividend.

This will not require Apple to "repatriate" the cash that it
holds overseas (to avoid taxes)--the logic that Einhorn uses to
explain why Apple shouldn't just do a huge share buyback.

Apple's U.S. business generates enough cash that Apple can pay
these future dividends out of its U.S. operations.

This will have pretty much the same effect as issuing preferred
stock that pays a dividend--except without needlessly
complicating Apple's capital structure.

Again, David Einhorn is brilliant. And, unlike mom and pop Apple
shareholders, David Einhorn will certainly be able to exploit any
inefficiencies in how the market is valuing two classes of Apple
stock. And David Einhorn may believe--and, importantly, may be
right--that he can persuade the market that Apple should be worth
more if it issues this preferred stock.

But, over the long haul, the market generally gets it right.

And "right" in this case is the observation that you can't create
something from nothing. (At least not with financial
engineering.)